Client Update – December 31, 2008

2008 will likely be the worst investment year that any of us will experience in our lifetime. Stocks had their worst calendar year since 1931. Almost every asset class was in the red for the year, with many deeply underwater, giving investors almost no place to hide. Clearly we are now in the midst of a severe recession with higher unemployment and other discouraging economic news over the next few quarters. Consumers are being forced to adjust to a new reality in which they finally have to pay down debt, increase savings and thus spend less than before.

While it may be that we have seen the market bottom, we can’t be sure. We are prepared for volatile markets and expect that the stock market will continue to experience strong rallies and subsequent sell-offs. These rallies could last for months with sizable returns, followed by sharp pullbacks. We have already seen a stock market rally of 18%, followed by a 25% decline, and a 21% rebound within the last few months. We don’t know if this is what the next few months will look like, but we believe this to be a likely scenario – this is how other severe bear markets have petered out over time. Unfortunately, this grinding process is what keeps most investors’ fear level up and their money on the sidelines and they miss the final real rally when it comes.

However, with a great deal of negativity already priced in the markets, the longer-term return outlook is decent. We believe we will continue to see numerous opportunities created in this highly dislocated environment. There is a mountain of cash sitting on the sidelines. In fact, since the advent of money market funds more than 30 years ago, money market assets relative to total stock market capitalization has never been higher. Some of that cash will find its way back into stocks and bonds soon, especially with returns on CDs and cash so low. Thus, despite the near-term caution, we think the weight of the evidence overwhelmingly suggests that investors, over the next few years, are likely to reap at least satisfactory returns much higher than the 0% to 3% currently offered on money market funds and CDs. Moreover, periods of extreme dislocation usually create opportunities for significant value-added from active management. While the entire stock market does not have to do well, there will be sectors that will do very well. Based on our read of history, as well as data that indicates extensive valuation discrepancies in current stock and bond markets, we believe that the next few years are likely to be good ones for active managers relative to the indexes, such as the S&P 500 or Dow, and certainly superior to CDs or money market funds.

As we look forward from here, starting with beaten-down financial markets and an economy on the ropes, we ask the question we always ask: What expectations are currently reflected in asset class prices? Historical comparisons are sometimes helpful. There have been two extreme economic and investment environments in the last 80 years—the 1930s, and the 1970s/early 1980s. In both periods investor confidence was crushed after lengthy periods during which returns were dismal and because of a continuation of negative headlines. But as it turned out, both periods presented a great opportunity. This may be a similar time. These experiences reflect the tension that investors face—when risk seems greatest it is usually a good time to invest.

Market Update

Markets are once again testing their lows and every investor’s resolve and patience. Economic conditions in some areas have improved, but in most areas continue to decline. The deterioration in the economy will be increasingly evident over the next few quarters in the unemployment numbers as consumers spend less and corporations lay off workers to offset their lower sales. Last year, unemployment was under 6%, it is currently at 6.5% and continues to rise. We expect it to top 8% before the economy turns around next year.

The massive government stimulus packages will top $1 trillion and likely take 2-3 quarters before the full impact of their economic benefit is felt. However, there are already some signs of improvement. The bond and credit markets have seen the beginning of a reduction in numerous risk spreads. This is an indication that money is beginning to circulate through the economy.

Usually during stock market declines bond prices move higher. However, from the middle of September to the middle of October this was not the case and many investment grade corporate bonds also lost 10% to 30% of their value during the panic selling. In the last several weeks as risk spreads have reduced, the normal relationship is being reestablished and bond prices are holding steady or moving higher even while the stock market declines.

As the overall political, economic and market conditions remain unclear and unstable, we understand that stability is at a premium. Thus, we continue to review the vast securities world for positions that will benefit your portfolio. Our approach is three fold:
1. Hold a majority of the portfolio in very safe securities where the yield is moderate (4% to 6%) and the risk to principal and volatility are very low.
2. Continue to hold only a small portion of the portfolio in the stock market.
3. Staying vigilant by watching the markets and looking for opportunities. We have found many securities that will add great value to the portfolios once the markets are more stable.

Market Update

There are three problems currently facing the economy and markets. First, too much credit was created for individuals, corporations, and government and it needs to be unwound. Individuals and corporations have begun that process and it will continue for several years. Second, the U.S. economy’s recession began near the start of 2008. Even though government statistics masked its existence, it was evident through common sense observation. Recessions are a natural part of the business cycle and need not be feared. They generally last 12-16 months, causing stock markets returns to be low or slightly negative for a few months and bond prices to rise, offsetting some of the stock market’s return. However, the third factor, the recent credit freeze, has caused a powerful flight from risk pushing virtually all security prices much lower. This, in turn, makes the first two problems worse.

The credit freeze is much like a financial heart attack. It does not matter what other illnesses the patient may have, because they become irrelevant if the heart cannot be restarted. If credit does not flow through the economy’s veins, then business will come to a halt. Every week that conditions were frozen will likely add one month to the patient’s recovery. Thus, we expect that the four weeks from mid-September to mid-October will add four months to our recession, taking us out to mid-2009 before conditions begin to look better. The stock market, however, will anticipate the recovery and begin to move higher before the news media can report improving conditions.

Client Update - October 24, 2008

Today we are seeing all the markets around the world sell off in historic proportions. Before the US markets even began trading this morning, orders to sell so overwhelmed the New York Stock Exchange that they halted additional sell orders from coming in until the markets opened at 6:30 am. This market activity is being caused by two very different but related events. The primary cause is the worldwide slowdown in economic activity. Secondarily, and more importantly for the next few trading days, forced selling of billions of dollars of assets by hedge funds will whipsaw the markets.

What does this mean? In the near term, the volatility in the markets will continue. We will see more days like this in the future, both on the upside and downside. Critically, the entire stimulus that world governments have put in place has not yet had a chance to work. Starting next week the Fed should begin to deploy the assets authorized through the historic bailout vote. As these assets are actually deployed, and similar stimulus plans are implemented, they will begin to more greatly influence the markets and more importantly the economies of the world.

In addition, we believe there will be an interest rate cut both here and in Europe next week. The world is no longer worried about inflation with oil dropping below $65 a barrel and home prices falling over 30% in many areas. No, the world is worried about deflation -- falling prices, earnings and economic activity. Governments around the world will throw all the money (ours and theirs) at this problem to try to head off a more serious recession than the one that is here now. These steps are in stark contrast to the actions leading to the Great Depression of the 1930’s. At that time, governments raised interest rates and cut off access to credit -- just the opposite of what policy makers are doing today. This printing and spending of money will eventually lead to much higher rates of inflation, but should help prevent a reoccurrence of that time in our history.

We have no doubt that we are in a severe economic slowdown. However, the markets will and are already overshooting to the downside just like they overshot on the upside in 1999-2000. There are many great values and opportunities being established both inside and outside the stock market. As an example, after the market crash of 2002 the bond market had returns of over 10% the next year and high yield bonds returned over 30%, which was more than the S&P 500.

Although we cannot dismiss the significant damage that has been done to markets, economies, and most importantly households, it is most important now not to panic, but instead seek information and make rational, reasonable decisions. We are carefully monitoring the economic and financial situation and will continue to strive to act in your best interest at every turn. Please contact us if you have any questions.

Client Update – October 10, 2008

A fundamental change to the financial system and the economy took hold in September. First, the bond/credit markets went into cardiac arrest during the month, intensifying mid-month, with limited trading going on, and a near run on money market funds. Bond prices on everything but Treasury securities suffered unusually sizable declines--corporate bonds and municipals were particularly poor performers. The stock market began to realize the impact of the deterioration in the already stressed credit markets and moved sharply lower. Days of wild swings followed as a rescue package was proposed, then stunningly defeated by the House, then resurrected as conditions continued to deteriorate. Even when finally passed, the markets were not impressed.

For awhile now, a capital infusion into the banking system has been needed so that financial institutions can take their losses (there are many more loan losses to come) and recapitalize. It is important that it be a system-wide solution. Action is needed both to address the underlying fundamental problem and to help bring confidence back to the market. A continuation of the extreme dysfunction in the credit markets will further damage the economy, with potentially long-lasting effects, including more financial institution failures and a deep economic downturn. In our view, coordinated action from governments around the globe is the best chance to begin to bring confidence back to the credit markets. Risks would still remain, but those risks would be significantly reduced. It is the credit market not the stock market that is the cornerstone of our economy.

Usually pessimism creates good buying opportunities because psychology comes into play and fear drives prices lower than what the long-term fundamentals suggest is reasonable. Longer term, there are some asset classes that are beginning to intrigue us. Driven by the sell-off in everything but Treasury securities, high-quality mortgage-backed security yields and corporate bond yields now suggest returns in the 6-10% range over the next few years once the credit markets return to normal. These are attractive returns--especially for tax-exempt accounts. High-yield bonds are looking more interesting, but default rates are likely to be very high for some time so investment there is still premature. But that could change quickly as this market is also getting hit hard.

Our current large position in U.S. Treasury Bills is transitional. Once conditions truly improve, we expect to deploy assets quickly into areas of the market offering higher yields and potential appreciation. We see many opportunities but, as of now, it is too early to move. For now, we are holding more in safe U.S. Treasury money market funds than ever before and a drastically reduced exposure to equities.

We would like to leave you with some thoughts that might be helpful in coping with this very challenging time. It’s important to remember that the more dysfunctional the markets get, the more opportunities we’ll have to add value with tactical moves. We are optimistic that the returns we will capture with our disciplined, valuation-driven approach could be quite good, as they were after the last bear market. Finally, know that our only incentive is to try to do what is in your best interest. Your needs, trust and confidence are most important to us and are the primary driver of what we do.

Client Update - September 22, 2008

In the past several weeks we have had many questions about market conditions and the safety of the money market accounts at the custodians we use. In order to update you, we have enclosed a market update and a report from the custodian for your assets detailing the protection afforded their accounts and money market funds.

To further protect the assets placed under our care, we have substantially all of our clients’ cash in U.S. Treasury money market funds which are the safest available. In contrast, Certificates of Deposit (CDs), that in the past have seemed so safe, are now causing investors much worry as they contemplate the fact that not only may their interest be at risk, their principal might also be in jeopardy if the issuing institution declares bankruptcy.

During the late 1980s and early 1990s almost 1,500 banks across the country went bankrupt. So far this year, only a few dozen banks have followed suit. We expect many more to follow, especially the small to mid-size banks. However, the banking industry will continue to play a vital part in the economic well-being of our country. Many banks are in very good condition, and the banking sector will offer some great investment opportunities going forward. This was confirmed by this morning’s news that Goldman Sachs and Morgan Stanley have applied to the government to become bank holding companies.

In summary, the custodians we use for your accounts are among the very safest in the world (safer than banks, savings & loans, and credit unions). Additionally, the money market funds we use are safer than other financial institutions, their CDs, or savings accounts. By design, we chose to place your funds only with custodians of the highest caliber in preparation for the remote possibility of the events we’ve all seen in recent weeks.

Client Update - September 21, 2008

While the past year has been full of major-headline financial news, we have experienced a lifetime of it recently and the past week alone has been nothing short of historic:

Sunday – Lehman Brothers, a 158 year old investment bank, declared bankruptcy after being unable to find any other firm around the world to merge with and the U.S. Government declined to help. Seeing the writing on the wall, 94-year-old Merrill Lynch agreed to be purchased by Bank of America for $50 billion (one-half of the company’s market value six months earlier).

Monday – Over the weekend AIG, the largest U.S. based insurance company, had gone to the U.S. Government and requested $20 billion to protect its credit rating, but was denied on Monday. The stock market was down 5%.

Tuesday – AIG was downgraded by credit rating agencies because of its weakening financial condition and plummeting stock price. The fear permeating the stock market now began to spread into the safer areas of the bond market. Usually a safe haven, most areas of the bond market began to drop as investors panic-sold bonds to (1) cover margin calls on their falling stock portfolios, and (2) move their funds into money market accounts. Late in the evening, AIG announced that the Government had provided the $85 billion necessary to boost its credit rating back up to where it had been on Monday prior to the downgrading. Yes, that’s right, what cost $85 billion on Tuesday would have cost $20 billion on Monday! The stock market was up 2%.

Wednesday – The fear permeating the stock and bond markets now began to spread into the very safest and most critical area of our financial system. Several well respected money market accounts announced that they were in jeopardy of principal losses and not being able to guarantee full return of the investors’ money. This caused further panic and selling in both the stock and bond markets. Financial system and economic problems appeared to be worsening and spreading. The stock market was down 5%.

Thursday – Realizing that a Depression-era run on the bank and a complete financial meltdown was at hand, the U.S. Government, after the stock market closed, announced that it would protect $3 trillion in money market accounts using the Exchange Stabilization Fund created in 1934. A mid-day rumor that this might occur and another that a bank bailout package was being discussed caused the stock market to rally late in the day from being down 2% to closing up 4% for the day.

Friday – The Government announced that a broad plan of policies and $700 billion in bailout programs are in the works to shore up our failing financial system. This news and the suspension of short-selling on 799 financial stocks pushed the market up 5% at Friday morning’s open before closing up only 4% for the day.

We have been exceedingly busy over the past weeks and months monitoring the financial markets and your portfolio. We will remain diligent in staying on top of the fast changing events. Thursday, when even money market accounts were in jeopardy, we came very close to moving all accounts substantially to the sidelines. However, due to various government bailout programs, we do not believe that it is best to be all out at this point in time. Nonetheless, we believe a more conservative stance is warranted. When the market recovery occurs there will be plenty of opportunities.

Client Update – July 15, 2008

The first half of 2008 dramatically reinforced the idea that over the short term the stock market is predictably unpredictable. A sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with the market dropping 8.4% for the month and almost 3% in the second quarter. The phrase "June gloom" is used by residents of the Southern California coast to describe the cold and fog that persists this time of year, and it could also be used to describe investors’ moods as the quarter came to an end. The S&P is now down 12% for the first half of this year, and is about 18% below its October 2007 high. The market offered few places to hide. Mid- and smaller-cap stocks fared better than large in the second quarter, but still got slammed in June and now have high single-digit losses for the first half of 2008. Vanguard’s Total International Stock Index also had a rough month, losing 9% in June and 2.2% in the second quarter. Foreign stocks are now down 10.9% through the first half. REITs were hit hard, dropping 11% for the month. Domestic high-quality bonds were flat in June and down just over 1% for the second quarter and up 1.1% for the year.

As always happens in an environment of fear, we are asking a lot of questions. What is going on, and how bad could it get? What else should we be doing in your portfolios? This environment is in many ways unique and presents its own set of challenges, which we’ll address more specifically in a moment. But more generally, we want to start by saying that we’ve been through a number of crises over more than two decades of managing portfolios, and while each of these periods presented its own particular challenges, one thing that is common to them all is that a sense of accelerating bad news, escalating risk, fear, and panic were almost always present.

Looking back to March, the Federal Reserve’s unprecedented actions to shore up credit markets and create liquidity led many to hope that we were past the worst of the financial crisis and that the stock market had hit bottom. Today it seems that while the Fed’s actions may have significantly reduced the risk and fear of a full-scale financial meltdown, the losses from bad loans are not only continuing, but are continuing to be worse than expected.

The positive impact of soaring home prices and easy credit is now gone, and with it has gone a major source of consumer spending. Add in the impacts of high levels of household debt, higher gas and food prices, a weakening labor market, and, by one measure, consumer confidence at a 28-year low, and it seems increasingly likely that consumer spending will continue to deteriorate. The damaging combination of a slowing economy and higher inflation has also led to questions about the ability of the Fed to support economic growth and employment without stoking fears that it has gone soft on inflation. At their latest meeting in June, the Fed held rates steady and expectations of higher rates later this year has also hurt stock prices. What it all means is that risks to the economy remain high, and the financial markets are now more fully discounting this risk, which is an unemotional way of describing the battering taken by stocks in recent weeks.

As always, there are positives. Outside the financial sector, corporate balance sheets remain generally healthy and earnings have been okay. One source of strength has been exports, which have managed to offset much of the impact of the housing decline on GDP. But this could diminish if our slowing economy means we also export economic weakness to the rest of the globe.

"History is merely a list of surprises. It can only prepare us to be surprised yet again." —Kurt Vonnegut

One possibility is that things will get worse before they get better. Even without a bad recession, fear and pessimism can take hold of investor psychology and send the market down further than what would be justified by long-term economic fundamentals. Though it is easy to put too much weight on negative scenarios when bad news dominates the daily headlines, our economy and financial markets generally find a way to work through all the problems and heal themselves. History is full of awful events if you look back over the years, but the economy is bigger and stronger and the markets are higher.

In this type of environment, a sense of perspective and a reliance on our investment discipline helps us avoid becoming panicked by short-term concerns and paralyzed by longer-term uncertainty. Like it or not, we are always faced with making decisions in an uncertain world and this will not change. However, our experience in past market cycles and our analysis of the current market environment leads us to two important conclusions.

First, as we have written in previous commentaries, we know that we can’t avoid all losses, but we do understand that it is our job to protect your portfolio from the full impact of a bear market. As such, we have adjusted most portfolios several times and significantly reduced stock market exposure. We know that it is prudent to be more defensive when little else is working. In due time, we’ll have the opportunities we need to produce the returns you need.

Second, big market downturns invariably present opportunities, and without them, we would not have had the chance to identify some of the tactical allocations that have added value to your portfolios over the last 18 years. Bubbles lead investors to make errors in judgment and misprice assets on the way up. On the way down, assets often fall to bargain prices when investors are in the grip of fear. Our investment discipline (and our focus on what is knowable) can help us identify those asset classes where investor panic has led to excessive undervaluation. Once again, there are several that may be headed in this direction that we are monitoring carefully.

For the 10 years through the end of June, the S&P 500 has compounded at just under 3% annually. From June 1988 to June 1998 the S&P 500 returned a whopping 18.6% annually. During this time interest rates fell, the growth rate for corporate earnings climbed, investors took their enthusiasm too far, stocks became overvalued, setting up the market decline from 2000 to 2002. So in a sense, the low returns of the past 10 years have forced investors to give back some of the excess earned in the previous decade. When both periods are combined, stocks have returned a little more than 10% annually in the 20 years through June 2008. That’s in line with their very long-term average.

Market conditions may continue to be challenging. However, we believe we can add value from both our tactical asset allocation and security selection decisions. In terms of our current portfolios, we continue to hold lots of extra cash as a margin of safety and to allow us to quickly deploy it back into the market to take advantage of the inevitable market upturn or any intermediate trading opportunities. Once the market begins its "real" upward movement we think an overweighting of large-cap growth stocks, foreign markets and high-yield bonds will add great value much like they did in 2003-2004.

We remain confident that our investments will beat their benchmarks over the long term. Many of the managers we use and respect tell us they are buying shares of high-quality companies at bargain-basement prices. Consequently, even though the overall market does not look compelling, the current economic and market turmoil is creating significant return opportunities at the bottom-up individual stock level. Indeed, it is often when the overall trend is negative that disciplined investors can build a portfolio for long-term outperformance by carefully taking advantage of the opportunities created by these dislocations. It requires patience and the ability to weight long-term analysis above short-term fear, but it is what distinguishes successful investors. At market tops and bottoms, what feels right isn’t. The proverbial mattress, or a CD may feel like the right thing today, but the odds are great that one year from now it will be obvious why they weren’t.